Could Economic Growth Withstand a Fiscal Cliff Plunge?

Last week's upward revision of the official estimate of GDP growth raises an intriguing question: Could the economy actually survive a fall off the fiscal cliff?

It's a question worth asking since this week's news from Washington has brought more posturing than progress on budget negotiations. Failing a deal, the package of spending cuts and tax increases due to begin on January 1 is thought certain to have a dampening effect on the economy.

GDP revision shows new momentum

Late last week, the Bureau of Economic Analysis issued a revised estimate of economic growth in the third quarter. The new estimate is that real GDP grew at an annual rate of 2.7% last quarter.

That 2.7% represents a sharp increase from the original estimate of 2.0%. It is almost twice the growth rate of the prior quarter, which was 1.3%. These healthy improvements create a distinct impression of an economy gaining momentum.

Placed in the context of the fiscal cliff negotiations, the question becomes one of whether that economic momentum is so strong that the economy could sail off that cliff and simply keep going.

Sailing off the fiscal cliff

Surviving the fiscal cliff is not unthinkable. For example, the Bush income tax cuts and the Obama payroll tax cuts were both supposed to be temporary measures -- and neither was necessary for the strong economic growth of the late 1990s. It's also worth remembering that the point of the fiscal cliff is deficit reduction, which remains a necessary goal. After all, debt is ultimately a case of pay-now-or-pay-later. The U.S. will have to settle that debt at some point.

Unfortunately, while the economy may have gained some momentum in recent weeks, it does not yet appear to have the strength to survive the full extent of the fiscal cliff's tax increases and spending cuts. The Economic Policy Institute has estimated the full economic impact of the fiscal cliff as a 3.7% drag on GDP. At the recent 2.7% growth rate, that would leave the economy next year at -1.0%, which means in recession.

In short, keeping the economy moving still requires doing something to smooth out the fiscal cliff, ideally without abandoning the goal of deficit reduction.

Interest rates in the balance

The nature of the solution will go a long way toward determining what kind of year 2013 is for interest rates. Falling off the fiscal cliff and into recession would almost guarantee another year of dismal interest rates for savings accounts, money market accounts, and other deposits. Mortgage and refinance rates would remain low, though in a recession loan approval would be harder to come by.

On the other hand, a fiscal solution that allows the economy to sustain its recent momentum could allow interest rates to turn upward by the end of 2013. In short, borrowers are unlikely to see a better year than 2012, but depositors just might.